Abstract
This Selected Issues paper analyzes the spillover effects of key external shocks on Paraguay. It presents an overview of Paraguay’s major economic and financial linkages with the rest world, and quantifies the spillover effects of key external factors on the Paraguayan economy, using a vector autoregression approach. The empirical results suggest that global shocks have a significant impact on Paraguay’s growth rate. The paper also highlights that output and exchange rate shocks stemming from Brazil and Argentina are also important, even after controlling for global factors.
Informality in Paraguay: Macro-Micro Evidence and Policy Implications1
A. Introduction
1. Paraguay’s economy features a high degree of informality. Based on different estimation approaches, informal activity represents more than half of total employment, and only a slightly lower share of measured output. This degree of informality is elevated, and at least according to some metrics compares unfavorably to Paraguay’s peers in Latin America and the Caribbean.
2. Informality has wide-ranging effects on the economy and may point to weaknesses in economic institutions or policies. This paper provides cross-country evidence suggesting that high degrees of informality are associated with characteristics typical of weaker, less advanced economies. Theoretical and empirical considerations support the notion that regulations, enforcement policies, and government effectiveness are the ultimate determinants of informality. However, the optimal combination of these policy tools to reduce informality is not straightforward and needs to reflect the specific circumstances and objectives of the country.
3. This paper is organized as follows. Section B briefly defines informality; Section C summarizes earlier work on the relative size of Paraguay’s informal economy; Section D provides cross-country evidence on how informality correlates with other dimensions of economic performance, before Section E turns to micro-level data for Paraguay and describes the links between informal employment and other outcome variables; Section F proposes a theoretical model to assess the incentives influencing informal activity and derive some policy implications; and Section G concludes.
B. Defining Informality
4. Informality is a multi-faceted phenomenon that defies an unequivocal definition, but ultimately relates to incomplete compliance with government taxes and regulations. Definitions of the informal economy are usually motivated by the available data and the specific research interest at hand. A fairly general definition is found in Loayza (1997), who, based on earlier work by De Soto (1989), defines the informal sector as “the set of economic units that do not comply with government-imposed taxes and regulations.” The International Conference of Labor Statisticians, in turn, has proposed a specific classification distinguishing informal enterprises and informal employment.
C. Informality: Putting Paraguay on the Map
5. The proportion of informal economic activity in Paraguay matches the median of the group of Latin American and Caribbean (LAC) countries, although other estimates point to above-average informality in Paraguay. High informality is typically associated with emerging and developing economies. Indeed, the size of the informal economy (in percent of GDP) in advanced economies is roughly half that observed in poorer economies.
6. Employment data suggest an unusually high degree of informality in Paraguay. A recent International Labor Organization (2013) study compares employment in the informal sector across 47 developing and emerging economies. Paraguay ranks in the top 3 of LAC countries with the largest share of employment in the informal economy.
Size of Informal Economy Around the World
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Author’s calculations based on Schneider (2013) and Vuletin (2008) Data correspond to Schneider unless otherwise specified.Size of Informal Economy Around the World
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Author’s calculations based on Schneider (2013) and Vuletin (2008) Data correspond to Schneider unless otherwise specified.Size of Informal Economy Around the World
(In percent of GDP)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Author’s calculations based on Schneider (2013) and Vuletin (2008) Data correspond to Schneider unless otherwise specified.
Employment in the Informal Economy
(In percent of total non-agricultural employment, latest year available)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Women and Men in the Informal Economy: A Statistical Picture, ILO, 2013.Employment in the Informal Economy
(In percent of total non-agricultural employment, latest year available)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Women and Men in the Informal Economy: A Statistical Picture, ILO, 2013.Employment in the Informal Economy
(In percent of total non-agricultural employment, latest year available)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Women and Men in the Informal Economy: A Statistical Picture, ILO, 2013.D. Linkages with Growth, Inequality, and Institutions
7. From a cross-country perspective, high informality is associated with higher levels of inequality, greater corruption, and lower-quality economic institutions. The following charts link the size of the informal economy (in percent of GDP) with several other dimensions of economic performance. The bivariate associations shown in the charts are supplemented by panel data regressions that include country-specific and time fixed effects.2 The regression suggests that a large informal sector is associated with weaker economic institutions and higher levels of inequality, though the results do not necessarily establish a causal relationship.
Size of the Informal Economy vs. Growth, Income, and Institutions
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Size of the Informal Economy vs. Growth, Income, and Institutions
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Size of the Informal Economy vs. Growth, Income, and Institutions
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
E. Informality, Labor, and Firms in Paraguay
8. The majority of employment in Paraguay is generated in the informal economy. Using the household survey “Encuesta Permanente de Hogares, 2013”, we assess the size of the informal economy using several alternative and complementary measures. Specifically, we apply four different trigger conditions to identify the share of the workforce in the informal sector: a) firm size: considers that anybody working in a firm with five or less employees belongs to the informal sector; b) pension fund participation: anybody contributing to a pension fund is considered part of the formal economy; c) tax ID: a worker whose firm has a tax ID belongs to the formal sector; and d) issuing invoices: a worker whose firm issues invoices/receipts on its sales is judged to be in the formal sector. According to these criteria, between 55 percent and 77 percent of the workforce is employed in the informal economy.
9. Workers in the informal sector are less well-paid than their peers in the formal sector—a difference that at least partly seems to reflect the constraints of informality. Monthly salaries in the formal sector are usually twice as large as those in the informal sector; and the workforce in the formal economy has, on average, four more years of education. Is this difference in terms of educational background sufficient to explain the large observed difference in salaries? To address this question, we estimate a Mincer equation for workers’ income levels. The findings show that the average salary of an informal worker is still around 40 percent below that of a formal worker, after controlling for individual characteristics including education, age, experience, and gender. Accordingly, it appears that informal sector employment imposes a distinct constraint on income generation, perhaps related to lower productivity and less favorable conditions for growth.
10. Poor workers are employed almost exclusively in the informal economy, which is concentrated in agriculture, construction, commerce, and other services. Males and females are similarly distributed between informal and formal sectors, indicating no significant gender difference. With regard to poverty, however, extremely poor and poor workers are found almost exclusively in the informal sector. This provides further suggestive evidence that workers in the informal sector have lower productivity. From a sectoral perspective, informal workers are mostly concentrated in agriculture, construction, and commerce. In contrast, the “electricity, gas, and water” sector has the lowest share of informal employment.
11. Formal firms face negative spillovers from informal firms. The World Bank’s ‘Enterprise Survey’ for Paraguay (2010) provides evidence on what are perceived to be the biggest constraints on the operation of formal sector firms.3 Almost 30 percent of respondents identify the ‘practices of competitors in the informal sector’ as the biggest obstacle to their operations. Moreover, around three-quarters of formal firms in Paraguay report that they have to compete against unregistered or informal firms.
12. For many firms, the practices of competitors in the informal sector’ constitute a major or very severe obstacle. The World Bank’s survey asks respondents to measure the strength of different obstacles. When asked about competition with informal sector firms, more than 40 percent of formal firms, and more than half of large formal firms, respond that they face major or very severe obstacles. Firms in the services and food sectors express the greatest obstacles posed by informal sector competitors.
Informal vs. Formal: Gender, Poverty Status, and Sector of Activity, 2013
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Author’s calculation based on the “Encuesta Permanente de Hogares, 2013”.Informal vs. Formal: Gender, Poverty Status, and Sector of Activity, 2013
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Author’s calculation based on the “Encuesta Permanente de Hogares, 2013”.Informal vs. Formal: Gender, Poverty Status, and Sector of Activity, 2013
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Source: Author’s calculation based on the “Encuesta Permanente de Hogares, 2013”.F. The Role of Public Policy
13. A model helps to illustrate how informality is determined by taxes, regulation, government effectiveness, and the penalties applied to illegal or informal activities. In order to formalize the rationale behind the choice of whether to operate in the formal or informal sector, we propose a dynamic general equilibrium model that encompasses the above elements. The model considers that regulations and taxes impose a cost on economic activity (captured by a tax on output, tauF), though this cost may be fully or partially circumvented, giving rise to the existence of informal markets. However, there is no free lunch on avoiding regulations, as three more elements interact in the model: the statutory penalty for tax evasion within the formal sector (s); a penalty for working in the informal sector (t); and government effectiveness (q), which determines the enforcement intensity through a probability of detection of informal activity. The outcome of this setup is a model where the informal sector, on the one hand, and tax evasion rates, on the other hand, are determined endogenously. The model is calibrated to the characteristics of a representative South American economy.
Do Practices of Competitors in Informal Sector Represent an Obstacle?
(In percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Souce: Author’s calculations based on Enterprise Survey dataset (2010).Do Practices of Competitors in Informal Sector Represent an Obstacle?
(In percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Souce: Author’s calculations based on Enterprise Survey dataset (2010).Do Practices of Competitors in Informal Sector Represent an Obstacle?
(In percent)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
Souce: Author’s calculations based on Enterprise Survey dataset (2010).14. The various policy tools have different effects on the occurrence of evasion and informality, precluding a simple assessment of the optimal policy mix. Indeed, the model illustrates that not all the policy tools at hand are equally useful with respect to lowering evasion rates and informality, respectively. The chart below shows a simple measure of effectiveness for four alternative policies.
Effectiveness of Different Policy Tools to Reduce Evasion and Informality 1/
(In percentage points)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
1/ Horizontal axis shows the change in the relevant informality measure implied by moving from the minimum to the maximum value of the respective policy tool.Effectiveness of Different Policy Tools to Reduce Evasion and Informality 1/
(In percentage points)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
1/ Horizontal axis shows the change in the relevant informality measure implied by moving from the minimum to the maximum value of the respective policy tool.Effectiveness of Different Policy Tools to Reduce Evasion and Informality 1/
(In percentage points)
Citation: IMF Staff Country Reports 2015, 038; 10.5089/9781498334600.002.A003
1/ Horizontal axis shows the change in the relevant informality measure implied by moving from the minimum to the maximum value of the respective policy tool.15. However, raising government effectiveness produces favorable results in all dimensions. Improving the performance of the government increases the probability of detecting informal firms and workers, and moving them toward the formal sector. Similarly, it raises the likelihood of detecting tax evasion, enhancing compliance in the formal sector. Although government effectiveness is defined somewhat narrowly in these terms, the result has more general plausibility: a more effective government (whether as an enforcer of rules or a provider of public services) heightens the relative cost of staying outside of the formal and law-abiding sector.
16. Higher penalties for informal activities, unsurprisingly, assist the effort to discourage informal output and employment, whereas higher penalties on formal sector tax evasion may increase informality. Tax enforcement policies are usually aimed at monitoring and disciplining registered firms. In this regard, the model results suggest that focusing enforcement actions on formal firms can be costly, in terms of encouraging migration to the informal sector. A better strategy, therefore, needs to include elements to incentivize informal firms to formalize themselves. A higher penalty for informality (or a bigger subsidy for formalizing) can achieve this result, as can a reduction in (unnecessary) regulatory and tax burdens.
G. Conclusions
17. Informality in Paraguay is at least as pervasive as in other countries of the region, posing a significant policy challenge. Some indicators show Paraguay on par with its LAC peers, though the incidence of informal employment appears to be at the high end of the spectrum for the region. Cross-country data show that high informality is associated with other unfavorable attributes, notably high inequality, corruption, and weak institutions. From a microeconomic perspective, informality in Paraguay dominates among workers with abnormally low incomes, even after controlling for other demographic factors. Informal firms not only suffer from low productivity, but also appear to affect negatively the performance of formal firms and workers.
18. Designing a strategy to reduce informality is not straightforward, though a few key elements are likely to be instrumental:
Improvements in government effectiveness, which raises the relative cost of staying outside of the formal sector. Civil service reform and related efforts to increase government efficiency and reduce corruption are critical in this regard.
Phasing out of unnecessarily onerous regulations, which in the case of Paraguay may include certain licensing and registration requirements that may also foster corruption. By contrast, Paraguay’s low tax rates are unlikely to be a major contributor to informality nor would tax reductions seem advisable from a broader macroeconomic perspective.
A suitable structure of penalties for non-compliance, although consideration could also be given to providing positive incentives for formalization.
References
De Soto, H., 1989. “The Other Path,” Harper & Row, New York.
International Labor Organization, 2013. “Women and Men in the Informal Economy: A Statistical Picture,” Second Edition.
Loayza, N., 1997. “The Economics of the Informal Sector: A Simple Model and Some Evidence for Latin America,” Policy Research Working Paper 1727, World Bank.
Schneider, F., 2005. “Shadow Economies of 145 Countries All Over the World: What Do We Really Know?” Working Paper 2005-13, Center for Research in Economics, Management and the Arts (CREMA).
Schneider, F., A. Buehn, and C. Montenegro, 2010. “Shadow Economies All Over the World: New Estimates for 162 Countries from 1999 to 2007,” Policy Research Working Paper Series 5356, World Bank.
Vuletin, G., 2008. “Measuring the Informal Economy in Latin America and the Caribbean,” IMF Working Paper 08/102.
Prepared by Mauricio Vargas.
To conserve space, details on the panel regression, and on other formal model results reported below, are relegated to a forthcoming IMF working paper.
The Enterprise Survey for Paraguay is representative of the non-agricultural economy in Asuncion and the surrounding business area.
